Readers of Asset Allocator will recall the importance of the “risk free rate” in capital markets theory from their studies.
It underpins the expectations for return “premia” for all asset classes for a given term. Based on policy rates, it’s risen dramatically, and now there are prospects of a pivot. What does this mean for asset allocation?
The most important “boring” number in finance
You can define the risk free rate as 10 year government bond yields, or for the short-term by looking at central bank policy rates: the US Federal Reserve for dollar-based investors, or Bank of England for sterling-based investors.
In academia, the risk-free rate is presumed to be relatively stable, and in real life it has also relatively stable, for an extended period of time before the 2008 financial crisis, and over a decade since the then until recently, albeit at a lower level.
It is the boring anchor in capital markets theory before all the excitement of market beta, alpha, or other factor risk premia get thrown into the mix. It’s the bedrock of returns.
Interest rates on the move
The rapid rise in Central Bank rates to fight inflation has therefore been a turning point for markets across all asset classes.
With spiralling interest rates in 2022, longer duration asset classes (whose valuations are more sensitive to a change in interest rates) such as growth factor equities, inflation-linked bonds and long-dated nominal bonds, suffered.
When interest rates peaked and then paused in 2023, the outlook for risk assets was transformed. Why? Because the hurdle rate for a higher risk investment to be attractive had become a lot higher.
Money market funds – which are closely aligned to central bank policy rates – began to look incredibly attractive, offering “near-risk-free returns”, which seemed compelling compared to the recent turmoil of the equity markets which seemed to offer “return-free risk”.
This has triggered a “dash for cash”, as investors have grown fatigued at market volatility and negative newsflow.
Investors who stayed invested through the bleakest part of 2023 were handsomely rewarded with a year-end rally, as market attention focused on the prospects of an interest rate “pivot” – meaning that central banks look increasingly likely to start cutting interest rates in 2024.
The prospect of a pivot
After such rapid and extreme tightening of monetary policy, and following a “pause” to let the effect of those interest rate changes sink in, the prospect of a “pivot” to lower interest rates could have the reverse effect on markets.
Cash begins to look relatively less attractive compared to risk assets, particularly as time goes on.
Longer duration equities such as growth factor see their valuations rise more rapidly than value factor equities.
Longer duration bonds should also benefit from interest rate cuts, so why not go very long duration now? We think it’s also important to consider the shape of the yield curve and note its current inversion (short-term yields are higher than long-term yields) means it’s worth being selective and adaptive when navigating the trade-off between yield, volatility and duration.
The year ahead
Whilst the prospect of a pivot seem a “when”, not “if” decision, how and whether policy makers perfect its timing based on the data remains to be seen.
Interest rates will by no means be the only factor driving markets in 2024: economic growth outlook, and bumpy declines in inflation trends are also key macro factors. There is also no shortage of known geopolitical risks that can flare up (for example Ukraine, Taiwan, the Red Sea and US and UK elections), in addition to all the unknowns too!
But if there is a pivot in policy rates, as the market now expects, then a light tailwind after a heavy headwind will be most welcome for risk assets as cash gets redeployed. It also provides some encouragement for the outlook for investors’ portfolios after a few bruising years of bad news.
Here’s to a pivotal 2024!
Henry Cobbe is head of research at Elston Consulting
